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Foolish Fundamentals: Book Value

Know your terms before you dive head-first into investing.

Book value is an accounting concept that reflects a company's value according to its balance sheet. It's equal to shareholders' equity, or the difference between assets and liabilities.

But is it a good measure of a company's worth? Book value once approximated a company's market value, when most assets, such as factories and land, were capital-intensive and appeared on the balance sheet. Today, however, as America's economy has become less industrial and more service-oriented, book value is a less relevant measure for investors.

Consider Motley Fool Inside Value recommendation Microsoft(NASDAQ:MSFT), for example. Its recently reported book value was about $48 billion. But that's far from a fair value for the company, given that Microsoft has a market value well north of $250 billion and holds more than $35 billion in cash and cash equivalents alone. Much of Microsoft's value stems from assets that don't register significantly on the balance sheet -- its intellectual property, talented employees, strong brand, and phenomenal market share, for example. Also critical are its competitive position and its growth prospects.

Book value can be a poor indicator of fair value for even a heavily industrial company. Imagine a company that owns a lot of land and many buildings. Over the years, the value of these assets is depreciated on the balance sheet, eventually to zero. But these assets are rarely worthless and can even appreciate in value over time. Such a company might actually be worth a lot more than its book value, while other companies can be worth much less. For these reasons, it often makes sense to largely ignore book value.

To learn more about how to make sense of financial statements, check out our "Crack the Code: Read Financial Statements Like a Pro" how-to guide (also known as an online seminar). Or give any of ourhow-to guides a whirl. More than 90% of those who've taken them have consistently given them high marks -- and besides, we offer a satisfaction guarantee, or you get your money back.